Dynamics of the Global Financial Crisis

1
Dynamics of the Global Financial Crisis

• Steve Keen
• UWS

2
Appalling guidance by neoclassical economists

• OECD World Economic Outlook, June 2007, p. 9
• the current economic situation is in many ways
  better than what we have experienced in years
• Our central forecast remains indeed quite benign
• a soft landing in the United States,
• a strong and sustained recovery in Europe,
• a solid trajectory in Japan
• and buoyant activity in China and India.
• In line with recent trends, sustained growth in
  OECD economies would be underpinned by strong job
  creation and falling unemployment.
• Jean-Philippe Cotis, Chief Economist
• Crisis began August 9 2007just 2 months later!
• BNP closes 3 funds with strong subprime exposure
• Different theory needed to understand crisis

3
Minskys Financial Instability Hypothesis

• Explanation for regular credit-driven cycles
  crises
• Economy in historical time
• Debt-induced recession in recent past
• Firms and banks conservative re debt/equity,
  assets
• Only conservative projects are funded
• Recovery means most projects succeed
• Firms and banks revise risk premiums
• Accepted debt/equity ratio rises
• Assets revalued upwards
• Stability is destabilising
• Period of tranquility causes expectations to rise

4
The Euphoric Economy

• Self-fulfilling expectations
• Decline in risk aversion causes increase in
  investment
• Investment expansion causes economy to grow
  faster
• Asset prices rise
• speculation on assets profitable
• Increased willingness to lend increases money
  supply
• Money supply endogenous money, not under RBA
  control
• Riskier investments enabled, asset speculation
  rises
• The emergence of Ponzi (Bond, Skase)
  financiers
• Cash flow less than debt servicing costs
• Profit by selling assets on rising market
• Interest-rate insensitive demand for finance

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The Assets Boom and Bust

• Eventually
• Rising rates make conservative projects
  speculative
• Non-Ponzi investors sell assets to service debts
• Entry of new sellers floods asset markets
• Rising trend of asset prices falters or reverses
• Ponzi financiers go bankrupt
• Can no longer sell assets for a profit
• Debt servicing on assets far exceeds cash flows
• Asset prices collapse, increasing debt/equity
  ratios
• Endogenous expansion of money supply reverses
• Investment evaporates economic growth slows
• Economy enters a debt-induced recession
• Back where we started...

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Crisis and Aftermath

• High Inflation?
• Debts repaid by rising price level
• Economic growth remains low Stagflation
• Renewal of cycle once debt levels reduced
• Low Inflation?
• Debts cannot be repaid
• Bankruptcy affects even non-speculative
  businesses
• Economic activity remains suppressed a
  Depression
• Big Government?
• Anti-cyclical spending enables debts to be repaid
• Renewal of cycle once debt levels reduced

7
Crisis and Aftermath

• Modelling Minsky
• Extension of Goodwins Growth Cycle to include
  debt
• 3 stylised facts
• Wages share grows if wage rises exceed
  productivity
• Employment rises if growth exceeds productivity
  population increase
• Bank lend money to finance investment
• Dynamics
• Borrow money to finance investment during a boom
• Repay some of it during a slump
• Debt to income levels ratchets up through series
  of booms/busts
• Eventually one boom where debt accumulation
  passes point of no return

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Modelling Minsky Endogenous Money

• Just one problem

Data a lot worse than the model!
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The Global Debt Bubbles

• Worse than the 1920s

• Models main missing ingredient
• Ponzi Investing

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Ponzi Finance

• Difference between model debt/output pattern

• Absence of Ponzi Finance in base model
• All borrowing leads to growth in productive
  capacity in model
• In Minskys theory (and in reality!), much of
  borrowing simply finances speculation on asset
  prices
• No addition to productive capacity
• But addition to debt!
• Modelled by introducing Ponzi Capital component

• And actual pattern

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Ponzi Finance

• Honouring irresponsibly created debt will lock us
  into a permanent slump

• Implies cant overcome crisis without debt
  reduction
• Via deliberate inflation or
• Widespread debt moratoria
• Problem too big to paper over

Ponzi model pattern closer to actual data
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The problem

• Debt/GDP twice as bad as prior to Great
  Depression
• USA
• 1929 150
• 2008 290
• Australia
• 1929 64
• 2008 165
• Common across OECD

• Position probably far worse once impact of
  derivatives, off balance sheet SIVs, etc. included

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Prospects

• Government deficit spending justified
• Cash flow to private sector assists debt
  repayment
• But scale of problem will overwhelm financial
  rescue
• Spending sum of GDP Change in Debt
• Last year GDP 1,080bn change in debt 259bn
• Change in debt20 aggregate demand
• Even debt stabilisation means drastic drop in
  demand
• Debt stabilisation 259bn cut to spending
• Debt reduction to say 75 GDP (triple 60s level)
• 100bn/year cut in demand for next 10 years?
• Government spending cant counteract this
• Witness Japan

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Omens

• Japans Bubble Economy crisis a precursor to
  Subprime Crisis
• Debt-financed speculative bubble
• Burst end-1989
• Two decades later, still in low level Depression
• Government debt far higher, private debt slightly
  lower
• But economy still mired in economic slump

Economy more indebted than ever...
Private Debt Bubbles Bursts...
Government pump primes (with debt)

• Cant pump prime way out of debt crisis this
  big
• Simply swaps public debt for private
• Debt should never have been issued in the first
  place

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Solutions?

• Only solutions involve drastic cut in Debt/GDP
  ratio
• Deliberate Inflation?
• Debt moratoria?
• Post-crisis reforms
• Palliative reforms (Glass-Steagall Act, etc.)
  will be reformed away once they cause prolonged
  stability
• Long term success only if possibility of
  profitable asset price speculation virtually
  eliminated
• Alter nature of share ownership
• Alter property valuation
• Re-assign risk from borrowers to lenders
• And think differently about the economy in
  future
• Less ideology (left or right!) and more knowledge

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Alternative economic theory needed too!

• Economic theory in part got us into this mess
• Ignoring role of money debt
• Fetish on equilibrium when economy far from it
• Naïve view of role of finance markets
• Efficient Market Hypothesis
• Insane view of rationality
• rationality as ability to predict the future!
• Didnt see this crisis coming
• Can you trust conventional (neoclassical) theory
  to
• Know what comes next?
• Get us out of it?

Not likely!

• Alternative theories of economics needed
• Some exist but are underdeveloped
• Best is Minskys Financial Instability Hypothesis

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Dont get fooled again

• Some other alternatives
• Post-Keynesian economics
• http//www.levy.org/
• http//cas.umkc.edu/econ/
• Evolutionary economics
• http//www.themeister.co.uk/economics/evolutionary
  _economics.htm
• http//www.business.aau.dk/evolution/
• Complex systems analysis Econophysics
• Physicists doing economics
• http//www.unifr.ch/econophysics/
• For more information analysis

www.debunkingeconomics.com
www.debtdeflation.com/blogs